Practical Applications of Factor Investing Using Capital Market Assumptions

Abstract

In <b><i>Factor Investing Using Capital Market Assumptions</i></b>, from the January 2022 quantitative special issue of <b><i>The Journal of Portfolio Management</i></b>, three Canadian researchers—<b>Redouane Elkamhi</b> and <b>Marco Salerno</b> of the <b>Rotman School of Management</b> at the University of Toronto and <b>Jacky Lee</b> of the <b>Healthcare of Ontario Pension Plan</b>—present a factor investing methodology far less complicated and expensive than existing practices by making use of publicly available capital market assumption reports. Most factor investing strategies require access to large databases and use costly proprietary mathematical models. In the hope of making factor investing possible for a wider range of investors, the team identified three macroeconomic factors that appear to be embedded in publicly available reports on capital market assumptions (CMAs): the rate of economic growth, the real interest rate, and the rate of inflation. Using these macroeconomic factors, they calculate asset class returns closely aligned to those in the CMAs. They then devised a formula to calculate the factor sensitivity of a sizable group of publicly traded asset subclasses, as well as a separate formula to price private assets. In addition, they developed a formula to reconcile their target factor weights with a portfolio that is built with constraints on diversification and risk.